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Dashed Expectations

Tim Geithner hopes to restore stability to the banking system by luring in private investors. The devil will be in the missing detail.
Economist Staff, The Economist
February 13, 2009

"We're going to have to hold out a Band-Aid a little bit...and just be clear about some of the losses," Barack Obama said of America's sickly banks this week. As much as $2.5 trillion buys more than a little bit of sticking plaster, one would hope. That is the sum of fresh money that Tim Geithner, Mr. Obama's treasury secretary, hopes to channel into the financial system through his overhaul of the Troubled Asset Relief Programme (TARP), in large part by using public funds to coax private investment.

Across the world, there is agreement on the need for a more comprehensive response to the crisis. European ministers this week discussed setting up "bad banks" to buy illiquid assets. Mr. Geithner, meanwhile, is keen to distance himself from the ad hoc approach of his predecessor, though his implicit swipes at Hank Paulson, with whom he worked closely on bail-outs, will strike some as unbecoming.

A pity, then, that his plan was more a statement of intent than a concrete proposal, lacking crucial details when, as he himself acknowledged, public distrust and anger over previous government efforts is running high. Markets reacted badly, with shares down (particularly in big banks) and safe assets, such as gold, rallying. Economists, even those supportive of Mr. Obama, were underwhelmed. "Maybe it's a Trojan horse that smuggles the right policy into place," mused Paul Krugman, grimly, at Princeton.

Most disappointment was directed at the sketchy plan to tackle banks' toxic assets, such as mortgage-backed securities and leveraged loans. At a late stage Mr. Geithner rejected the idea of a government-run bad bank (as well as blanket guarantees for noxious assets), put off by the high upfront cost and the problems it would have valuing the debt. He now hopes to amass $1 trillion of buying power by drawing in investors, such as private-equity groups, whose inclusion would stretch the government's money further and bring more discipline to pricing.

Fine, but Mr. Geithner still has a yawning gap to bridge between banks, which do not want to sell at depressed prices because of losses they would have to recognise, and potential buyers, who need to be sure of healthy returns. It was this that put paid to both the original TARP and Mr. Paulson's efforts to rescue structured-investment vehicles. Distressed-debt investors, such as Blackstone and BlackRock, are interested but want more information. To be sure of attracting them, the government might need to provide a combination of cheap loans and a guaranteed floor on losses. But even then, the mooted public-private partnership may not be big enough. Barclays Capital counts $2 trillion-3 trillion of troubled assets in America, excluding prime mortgages, which are souring fast.

The plan also falls short in its treatment of the root cause of the crisis: housing. The $50 billion programme to curb foreclosures is modest and short on detail. It is not clear, for instance, if it will include incentives for mortgage lenders and servicers to write down borrowers' principal, which may be the only way to stop the rot-though more details are expected in coming weeks. Mr Paulson fought to keep foreclosure mitigation out of the TARP, preferring to focus on strengthening financial firms. That is no longer an option. Mortgage relief is "the pound of flesh demanded by an angry public" for the cost of the bank bail-out, says Stephen Stanley of RBS Greenwich Capital.

A more promising feature is the fivefold expansion of a $200 billion Federal Reserve lending facility for buyers of securities backed by consumer loans, the market for which collapsed last year. Reviving important non-bank funding sources, such as securitisation, is essential, even if its huge expansion in the credit boom led to the mispricing of risk.

The hope, however peculiar it sounds, is that, just as leverage got finance into this mess, it can help get finance out again. The facility will deploy $9 of Fed loans for every dollar of TARP funds-the central bank can in effect print money at will. Encouragingly, hedge funds are itching to take advantage of the attractive financing terms. But dealing directly with them, and ensuring they do not game the system, will take regulators into uncharted territory.

It is banks that matter most, however, and some of the biggest are suspected of being insolvent or close to it. That poses a dilemma for Mr. Geithner: he will not let the giants fail, yet he is determined to avoid nationalising them. (Indeed, the plan was apparently rushed out, perhaps before it was ready, in part to put such talk to rest.) He envisages a new round of capital injections, with the government taking preferred shares convertible into the common variety, as needed, to bolster banks' cushions against losses.

His plan also calls for banks with assets of more than $100 billion to undergo "stress tests" to determine their ability to withstand a severe and lengthy recession. The results will be ugly for some, given how slow they have been to build reserves and acknowledge dud loans.

Congress and the public are in no mood to keep ploughing capital into ailing giants-Citigroup and Bank of America have already taken $45 billion apiece, plus extensive asset insurance-without more drastic consequences. Nationalisation may be unAmerican, but the mood is turning even more sharply against the nationalisation of losses while profits largely remain in private hands.


Bankers complain that they are already in the grip of government. Citi can barely move without first getting Treasury or Fed approval. Following executive-pay curbs announced on February 4th, the new plan restricts dividends to a penny, forces banks to step up mortgage modifications and bans acquisitions of healthy competitors until the taxpayer is repaid.

It might have been even harsher, had Mr. Geithner not fought off calls by White House aides who wanted to, for instance, set firm lending targets. Instead, banks will have to submit plans explaining how they intend to "preserve or generate new lending". This should give them wiggle room, which may be no bad thing given the disastrous record of forced lending.

The shackles will surely tighten, however, if more money is needed from Congress once the $700 billion TARP (now renamed the Financial Stability Plan) is exhausted. That seems all but certain, given the speed with which the industry is deteriorating. The most pessimistic forecasts now put the number of American banks that could fold over the next five years at 1,000, six times more than are presently on the regulatory problem list.

All the more important, then, to get this plan right. "This is the last bite of the apple before bail-out fatigue overwhelms us," says one banker. But there are many blanks to be filled in. The biggest challenge will be to crack the pricing puzzle and get impaired loans moving in a way that works for banks, vulture-investors and the taxpayer. So far in this crisis, policymaking has been "behind the curve", Mr Geithner acknowledged this week. Yet again he failed to get ahead of it.




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